50/30/20 Rule: A Complete Guide
What You Should Know
- The 50/30/20 rule allows you to allocate your after-tax income among necessities, luxuries and savings.
- This rule suggests you allocate 50% of your after tax income towards your needs, 30% towards your wants and save the other 20%.
- The 50 30 20 rule accounts for your net income and not your gross income, which means that you have to subtract income tax from your gross income.
What Is the 50 30 20 Rule?
The 50 20 30 rule is a simple budgeting rule that may help you allocate your monthly income between your needs, wants, and savings effectively. The 50 30 20 budget implies 50% of your after-tax income is spent toward your needs, 30% of it is spent towards your wants and 20% is for savings, student loans, and other debt repayments. This budgeting method allows you to allocate your money efficiently among only three categories, which makes it easier for you to track and analyze your spending habits.
The 50 20 30 rule was originally found in the book called, “All Your Worth: The Ultimate Lifetime Money Plan.” Using this rule, you should be able to efficiently cover most of your needs and wants as well as build an emergency fund or contribute towards debt payments. This rule can apply universally because it does not change depending on the amount of money you earn. Instead, it ensures that you get to cover your needs and some wants as well as save money and pay off debt such as credit card debt.
How 50/20/30 Rule Works
This rule allows you to easily budget your personal finances and allocate your after-tax income into 3 main categories such as needs, wants and savings. It is important to note that the rule implies after-tax income because different regions may have different income tax brackets, so there is no simple way to allocate a certain percentage of income towards taxes. Once you pay your income taxes, you can break down your net income into the following categories.
50% for Needs
This category includes the bills that must be paid regardless of the amount of money you earn. These bills may include rent or mortgage payments, car lease payments, minimum credit card debt payments, groceries and other items required for living. Allocating 50% for the needs allows you to spend comfortably within this category and still have enough money to allocate for wants and savings. The needs category does not include non-essential items such as dining out, Uber rides or a Netflix subscription.
If you spend more than 50% of your income on your needs, you may want to consider downgrading your lifestyle. Even though mortgage and rent payments tend to be the necessities, some people may choose an overly luxurious lifestyle that includes living in an expensive property and driving an expensive car. If your needs take up more than 50% of your budget, you may need to consider moving into a cheaper place, getting a cheaper car or moving to a public transport altogether.
30% for Wants
The wants category is another important section to consider. You should allocate around 30% of your after-tax income towards your wants. This category includes things that are not essential to your lifestyle, such as dining out, Uber rides, and many others. The wants category includes optional items that do not affect your lifestyle drastically.
It is always best to lower the share of income that goes towards wants because you will get to save more instead. For example, you can save money by cooking at home instead of eating out, and you can generally avoid buying small items that you do not need. You should consider your spending habits to see how you can save your money on wants.
Generally, you do not have to restrict yourself from spending your money on wants if your spendings stays within 30% of your income. It may be difficult to restrict yourself from buying the things you want all the time, so it is important to make sure that you are happy with the purchases you make. On the other hand, if your budget for wants surpasses 30%, you should definitely try to find ways to lower your spending.
20% for Savings
The rest of your after-tax income should go towards paying off your debt, saving and investing. This part is essential to having a healthy long term budgeting strategy. It is also important to understand how to allocate the money between the debt payments, savings account and investment accounts.
If you have some expensive debt, such as credit card debt or personal loans, it may be beneficial to try to pay them off before saving and investing. By paying off expensive debt, you lower the amount of interest you will have to pay in the future, and you may also improve your credit score. With less interest to pay, you may even be able to afford to spend more on your needs and wants.
Once all high-interest debt is paid off, you should consider building an emergency fund to offset unexpected costs if they arise. An emergency fund may help you protect yourself from getting into expensive debt when accidents occur. Once you have built an emergency fund that you are comfortable with, you can start saving for retirement and investing your money.
You should ensure that you use the retirement options available to you. For example, IRA and 401k accounts are special tax-free accounts that allow you to save money for retirement. A 401k account allows you to deduct the contributions from your taxable income and invest the money you have contributed. It is important to note that there are certain limitations and penalties associated with 401k withdrawals before the retirement age.
A Step-by-Step Guide to 50/30/20 Budgeting
There are three steps that you can undertake to make sure that you are following the 50 30 20 rule. These steps can help you organize your budget and make sure that you stay on track with the rule.
1. Estimate Your After-Tax Income
The first step of getting your budget is to understand how much money you actually take home. The rule 50 30 20 uses the after tax income, so you need to take away your taxes from your gross income before budgeting your items. Regardless of whether you are calculating monthly or annual budget, you simply have to make sure that you account for taxes.
2. Look at Your Past Spending Habits
To understand how well you are budgeting your money, you can look at the previous months. You can download your bank statements and categorize each item in the list into one of the three categories: needs, wants and savings. Don’t forget to check your credit card statements too because there may be items included that are stretching your budget.
It is important to remember what items should be categorized as necessities and what items should be included in the wants section. The need section should include only essential items while the rest should go towards the wants category. Sometimes even essential items such as rent can be a luxury item, so it is important to clearly reflect on your spending.
3. Reflect and Adjust Your Budget
Once you have a clear picture of where your money goes, you can think about how you can adjust your spending to fit them into the 50 30 20 rule. The best way to start adjusting the budget is to look at your wants and see what can be reduced. Make sure to keep yourself relatively comfortable with your spending by avoiding making extreme changes.
It is great to save more than 20% of your budget, but make sure that you are happy with simplifying your lifestyle before cutting spending drastically. Extreme changes to your budget may be difficult to handle, which may lead to spending even more money than before.